Get Ready for the Xbox Shootout

November 17, 2005

Gamers are gearing up for the launch of Microsoft's (MSFT) Xbox on Nov. 22, just in time for the important holiday season. Leading console maker Sony (SNE) is behind this time -- it will release its PlayStation 3 in the spring of 2006.

"It should be a very exciting cycle," says Jonathan Rudy, who follows software stocks for Standard & Poor's Equity Research. "It will be interesting to see how it plays out technology-wise -- whether PlayStation can hold the lead this cycle, or whether Microsoft will win out."

ALL ABOUT BUZZ. With the addition of new multimedia functions, like playing video games over the Internet against other players, Rudy thinks hard-core gamers will be out in force buying the new consoles (see BW Online, 11/18/05, "Slide Show: Xbox Game Titles").

Karyn McCormack of BusinessWeek Online spoke with Rudy on Nov. 16 about the group and his favorite stocks. Edited excerpts of their conversation follow:

Note: Jonathan Rudy is a Standard & Poor's Equity Research analyst. He has no ownership interest in or affiliation with any of the companies on which he writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed here.

What does the new Xbox console mean for Microsoft? I've heard a few money managers cite that as a reason to be bullish on the stock.

It's definitely generating a lot of buzz for Microsoft. People are excited about the whole brand of the Xbox. Revenue-wise, last fiscal year, its whole home and entertainment division was about 8% of revenues. So for a company like Microsoft, which is running at roughly $40 billion in annual revenue, it's not so much the initial impact.

They've come from out of nowhere essentially a cycle ago, to becoming a solid No. 2, to having the first-mover advantage in this cycle. That was a huge advantage for Sony's PlayStation 2 last cycle, as far as getting the economies of scale and building out the installed base to generate the buzz and excitement.

That's where Xbox 360 has beaten PlayStation 3 to the punch this year. So it will be really interesting to see whether Microsoft is able to leverage that advantage into a No. 1 position this cycle [see BW Online, 10/25/05, "Inside IBM's Xbox Chip"].

It's difficult to really weigh exactly what it will mean in pure dollars this fiscal year, vs. down the line, where once you build out the installed base and become the No. 1 or a close No. 2 player, you deal with a huge installed base. Then you can sell a bunch of software into that installed base.

What's so great about the new consoles?

It's faster chips, better graphics, and more multimedia capabilities, like DVD players built in, and more music-oriented features. Xbox has a feature called Xbox Live where you can buy the headset and play vs. your friends through the Internet. That's developed more of a buzz, and it's really been an interesting feature.

It started last cycle a little bit but as broadband connections have continued to build out, I would look for that to be a more popular feature in this next cycle.

Which console do you think will be more popular and successful, the new Xbox or Sony's PS3?

Last cycle, clearly, PlayStation 2 was No. 1, Xbox was No. 2, and Nintendo's GameCube was No. 3. With the first-mover advantage, it will be interesting to see if Microsoft can really build out that lead and generate the buzz this cycle. Nintendo's next-generation GameCube is called Revolution, and that's scheduled for next summer tentatively. Not only is Microsoft a solid No. 2, it's definitely a threat to become the No. 1 player.

There was a lot of concern last cycle with Japanese developers, which were a little hesitant to build games for the Xbox because Microsoft didn't have those relationships. And they were concerned about how committed Microsoft was to the gaming industry. They learned little nuances like that by going through a cycle.

It will be an interesting battle. You never want to sell PlayStation short, but as long as Xbox 360, technologically, is comparable to PlayStation 3, Microsoft has a shot at unseating Sony.

Are there enough games for the Xbox?

Initially, for the launch, I believe there are roughly 16 to 18 titles for Xbox. So it's not huge, but again, it's the buzz. There will certainly be a shortage of actual consoles available at retail outlets, so that's going to create an excitement and buzz around it.

The games will follow. There are definitely some quality games -- Electronic Arts (ERTS) has most of their sports titles available, and Activision (ATVI) has some quality games ready [see BW Online, 11/02/05, "EA: Gaming for Console Domination"].

Why will there be shortages of the Xbox?

It's a delicate balance. You want at some point to have shortages because that's what generates the excitement. This usually happens every cycle. I'm sure they're cranking them out.

Microsoft said within the first 90 days they want to sell between 2.5 and 3 million units. That's a pretty good number. At least if you have a shortage around the initial launch, that's what really gets people excited and creates that buzz.

What's your growth outlook for the makers of video-game software, such as Electronic Arts?

Obviously, this is going to be a down year -- the fiscal year ending in March, 2006 -- for Activision, THQ (THQI), and Electronic Arts. This is the transition year. This was a much better transition year, historically speaking.

Earnings will likely be flat to down for the companies, broadly speaking. But this is clearly a secular growth area. In fiscal year 2007, there should be nice double-digit growth across the board. Looking out to fiscal 2008, it's kind of tough, but I would say after this year, there should be strong earnings growth. We're probably looking at 15% to 20% growth for the software makers.

Do the hot video games drive sales of the new consoles, or does it work the other way around?

It depends. One advantage of Sony's PlayStation 2 last cycle was Grand Theft Auto was PlayStation only. That has changed for this cycle. I believe last July, Microsoft signed a deal with Take-Two (TTWO) to get Grand Theft Auto for the Xbox.

So really, the buzz is about the consoles, and the games will follow. But as you get later into the cycle, it's the games that keep the buzz going and that keep the interest in the platform. It is similar to the movie season, where you get that big hit, like Halo or Grand Theft Auto, that tends to give sales a jolt after the initial excitement wanes.

What are your favorite stocks that stand to benefit from the popularity of games?

We just upgraded Electronic Arts to 5 STARS (strong buy) as a play on the cycle. It's actually acted pretty well lately. I wanted to try to get ahead of the console cycle because it will be a longer move than just this initial blip. They're the market leader, with a very strong balance sheet -- about $2.4 billion in cash and investments with no debt.

[EA has] the best brand library in the business, in my view -- Madden, FIFA Soccer, NCAA Football, Harry Potter, Lord of the Rings, Need for Speed, The Sims -- they have mastered a diversified brand library. They have a number of very strong titles and clearly the highest quality.

Beyond that, Activision is 4 STARS (buy). It also has a high-quality balance sheet. It may not have the extensive library that Electronic Arts has, but it has done a very good job of cultivating their brands and developing a nice core. Spiderman, X-Men, and Tony Hawk are some of their key brands. Call of Duty is another big one. And Gun is a popular one for the next cycle.

THQ is a 3 STARS (hold). [It has] more kids- and younger-oriented games like WWE, Nickelodeon brands, and Pixar brands like The Incredibles.

Take-Two Interactive is also a hold, and it makes Grand Theft Auto.

As for the console makers, Microsoft is 5 STARS (strong buy). Sony is ranked 2 STARS, or sell.

So you think demand for the new consoles will be strong?

It's just a really exciting time. With everyone worried about the consumer, the hard-core gamers are going to be out in force buying these platforms -- and there's going to be lot of excitement around it.

It truly is a secular growth area, and it's interesting with the addition of the multimedia features -- the DVD players, the music, online gaming aspects of it. It should be a very exciting cycle. It will be interesting to see how it plays out technology-wise -- whether PlayStation can hold the lead this cycle or whether Microsoft will win out.